To honor Martin Feldstein's distinguished leadership and extraordinary contributions to the National Bureau of Economic Research, the Feldstein Lecture addresses an important question in applied economics, with an application to economic policy. In this inaugural lecture I consider macroeconomic policy during the financial crisis.
It is useful to divide the financial crisis into four phases: 1) the "root cause" period from 2003 to 2006; 2) the period from the flare-up in August 2007 to the panic in September 2008; 3) the panic period in September-October 2008; and 4) the post-panic period. Here I look at the fourth phase and focus on monetary policy. (1)
I emphasize real time policy evaluation because the crisis is ongoing and because the research is quite different from many existing monetary policy evaluations that examine policy over decades. (2) The financial crisis has made real time evaluation essential because of the rapid changes in events and policy. In addition to loads of new data and policies, real time evaluation must address new methodological questions about the use of high frequency data and simulation techniques. (3) Because of blogs, the 24-hour news cycle, and the rapid spread of ideas, the need for real time policy evaluation is here to stay.
To evaluate monetary policy during this period I develop a specific quantitative framework in which I compare actual policy with certain counterfactual policies. It is not enough to say that policy is good or bad in the abstract; you need to say "compared to what" and be able to measure the differences. Such a framework requires that one characterize actual policy and then choose an appropriate counterfactual policy. Both are difficult tasks and there are alternative ways to go about them. What is most important, in my view, is the quantitative framework that different researchers can use in different ways.
Actual Monetary Policy since the Panic of 2008
First consider actual policy. In early September 2008, the Fed's target for the federal funds rate target was 2 percent. Starting during the week of September 17, 2008, bank reserves and the monetary base rose sharply, as shown in Figure 1, above levels required to keep the federal funds rate on target.
[FIGURE 1 OMITTED]
Why did reserves increase so much? The Fed created them to finance loans and purchase securities. Some have argued that they were increased to accommodate a shift in money demand, or a decline in velocity, but the drop in interest rates suggests otherwise. Reserves continued to increase through the end of 2008 and have remained elevated since then as the Fed has financed its purchase of mortgage backed securities (MBS) and long-term Treasury securities, made loans to banks through the Term Auction Facility (TAF), and to foreign central banks, to AIG, and so on. The large level of reserves has raised questions about how and when the Fed will exit from it.
Note that this quantitative easing began before the funds rate hit zero. Indeed, the increase in reserves eventually drove the interest rate to zero, which the Federal Open Market Committee (FOMC) then ratified. To see this, consider the timing of FOMC decisions. On October 8 the FOMC voted to cut the funds rate to 1.5 percent from 2 percent, but for the two weeks ending October 8, the funds rate was already well below 2 percent, averaging 1.45 percent. On October 29 the FOMC voted to cut the funds rate to 1 percent from 1.5 percent, but for the two weeks ending October 29, the funds rate was already well below 1.5 percent, averaging .76 percent. Then, on December 16, the FOMC voted to cut the funds rate to 0-.25 percent from 1 percent, but for the two weeks ending December 17, the rate was already in that range, averaging. 14 percent. Thus, decisions to increase reserve balances, rather than the FOMC decisions about the target rate, drove down the funds rate.
Choosing a Counterfactual Monetary Policy
What is a reasonable counterfactual monetary policy? …